Should my business be an S-corp or an LLC?

An LLC is a legal entity; an S-corporation is a tax election that an LLC or a corporation can make. The election matters because it lets an owner split earnings between reasonable salary and distributions, and distributions are not subject to self-employment tax. It costs payroll administration and requires defensible compensation, so it starts to pay above a profit level, not at formation.

Key points

An LLC is a state-law legal entity, while an S-corporation is a federal tax election that an LLC or a corporation can make.
By default, a single-member LLC is taxed as a sole proprietorship and a multi-member LLC as a partnership, and all profit carries self-employment tax.
After an S-corporation election, the working owner must take a reasonable salary through payroll, and remaining profit can be distributed without self-employment tax.
The S-corporation election requires running payroll, filing Form 1120-S, and defending the owner's salary as reasonable for the work performed.
The election only pays once profit is high enough that employment-tax savings on distributions exceed the added payroll and filing costs.

What is the difference between an LLC and an S-corporation?

An LLC is a legal entity created under state law. It gives the owner liability protection and a flexible legal structure, and it exists whether or not any tax election is ever made. An S-corporation is not a separate kind of entity; it is a federal tax election made on Form 2553 that an eligible LLC or corporation can choose. So the real decision is not LLC versus S-corp. It is whether your LLC should make the S-corporation election.

By default, a single-member LLC is taxed like a sole proprietorship and its profit is reported on Schedule C of the owner's Form 1040. A multi-member LLC is taxed as a partnership and files Form 1065. In both cases the full business profit flows to the owners and is subject to self-employment tax, which funds Social Security and Medicare. On a profitable business that tax adds up quickly.

How does the S-corporation election change how profit is taxed?

Once the S-corporation election is in place, the owner who works in the business must be paid a reasonable salary through payroll. That salary carries employment tax like any wage. The profit left after salary can be taken as a distribution, and distributions are not subject to self-employment tax.

Splitting earnings between a defensible salary and distributions is the core reason owners make the election. The employment-tax saving comes only from the distribution portion, which is why the salary has to be genuine. Paying an artificially low salary to shrink employment tax is the specific pattern the IRS examines in S-corporation returns.

What does the election cost in administration?

The election brings obligations that a default LLC does not have. You must run actual payroll, which means a payroll provider, quarterly employment-tax filings, and year-end W-2 wage forms. You must file a separate S-corporation return on Form 1120-S every year and issue a Schedule K-1 to each shareholder.

You must also be able to defend the salary you set as reasonable for the work you actually do, using comparable wage data documented at the time the salary is set. A CPA or payroll provider handles the filings; the compensation analysis is a planning task that should be done before the year begins, not reconstructed afterward.

When is the S-corporation election not worth it?

At low profit, the employment-tax savings on distributions are smaller than the added cost of payroll, a separate return, and compliance, so the election loses money. As profit grows, the savings on the distribution portion eventually outrun those costs, and that crossover is where the election starts to make sense. The exact point depends on your profit, your reasonable salary, and your state's treatment of S-corporations, which is why it should be modeled rather than guessed.

The election can also be unavailable or a poor fit at any profit level. An S-corporation may have only one class of stock and a limited number of shareholders, and shareholders must generally be U.S. individuals, certain trusts, or estates. Partnerships, corporations, and non-resident aliens cannot hold shares. A company planning to raise venture capital or issue preferred stock usually needs a C-corporation instead. The practical path is to form the LLC for its legal protection, then treat the election as a separate decision revisited as profit grows.